Saturday, April 29, 2017

Home Capital Group - it is time for the Canadian regulator to act

Home Capital Group is an aggressive Canadian home lender that has hit a very rough patch. If you want a history Twitter will do it well. They have been fighting with Marc Cohodes (a very well known short seller) and you will find a timeline of the unfolding disaster by following Marc's tweets. [Disclosure: I have known Marc for 17 years and we are friendly.]

The crisis came this week when Home Capital Group entered into an emergency loan. The press release is here - but the salient points are repeated below.

TORONTO – April 27, 2017 – Home Capital Group Inc. (“The Company” TSX: HCG) today announced that its subsidiary, Home Trust, has secured a firm commitment for a $2 billion credit line from a major Canadian institutional investor.

The Company also announced it has retained RBC Capital Markets and BMO Capital Markets to advise on further financing and strategic options.

The $2 billion loan facility is secured against a portfolio of mortgages originated by
Home Trust.

Home Trust has agreed to paying a non-refundable commitment fee of $100 million and will make an initial draw of $1 billion. The interest rate on outstanding balances is 10 per cent, and the standby fee on undrawn funds is 2.5 per cent. The facility matures in 364 days, at the option of Home Trust.

The facility, combined with Home Trust’s current available liquidity, provides the Company with access to approximately $3.5 billion in total funding, exceeding the amount of outstanding High Interest Savings Account (HISA) balances.

Home Trust had liquid assets of $1.3 billion as at April 25, plus an additional portfolio of
available for sale securities totalling approximately $200 million.

Access to these funds is intended to mitigate the impact of a decline in Home Trust’s HISA deposit balances that has occurred over the past four weeks and that has accelerated since April 20. The Company will work closely with the lender to have the funds available as soon as possible.

This on the face of it is an extraordinary loan. It is secured by giving the collateral and costs something between 15 and 22.5 percent depending on how much is borrowed.

Its also extraordinary because of what it does not mention. It does not mention who the lender is and it does not delineate what the precise capital is.

But we know that this is being used to pay High Interest Savings Balances. We know there is a run on the bank here here and the run is several hundred million dollars per day.

This is desperation financing. They are securing mortgages (average interest rate below 5 percent) to borrow funds that cost 15 percent or more. The negative carry is huge. A financial institution cannot stay in business under these terms.

The stock reacted - dropping 60 percent in a day. The Canadian exchange busted some trades about $8.20 (because it thought that they were done in error). Mine were amongst the busted ones. I was perfectly happy to sell at that price however in their wisdom the exchange thought that mine was a fat-finger trade. [Disclosure - transaction to sell 30,000 shares at 8.19 was reversed.]

--

Anyway the next day we found out who the lender was. It was the Healthcare of Ontario Pension Plan (HOOP). This was unusual because Jim Keohane was on the board of Home Capital and also the CEO of HOOP. Likewise Kevin Smith - Home Capital's Chairman - was on the board of HOOP.

The cries of conflict of interest were loud and undeniable.

The next day Keohane resigned from Home Capital's board and Smith resigned from HOOP's board.

--

Then (Friday Canadian time) Jim Keohane gave the most extraordinary interview. You can find the whole thing here:

a). The loans are secured by 200 percent of their value in mortgages (which makes the investment almost riskless - and Mr Keohane goes to some lengths to describe how low the risk is), and

b). Me Keohane says the deal is more akin to a "DIP deal". DIP stands for debtor in possession and he is thus saying the deal is bankruptcy finance.

This is an extraordinary position for Mr Keohane to take. He was an insider to both institutions (a true conflict of interest).

What he is saying is that he isn't taking any risk because he has taken all the good collateral and he expects Home Capital go go bankrupt.

And note that he will make 15 to 22.5 percent return (more if the loan is repaid early in a liquidation) whilst taking no risk.

I have two words to say to this: fraudulent conveyance. In a rushed deal (one that truly surprised the market) done with undisclosed insiders up to four billion of the collateral and maybe three hundred million dollars of book value has been spirited away. And at basically no risk the recipient of all this largess.

Wow that was audacious. More audacious than just about anything I have ever seen on Wall Street.

Jim Keohane seems to recognise what he has said because almost immediately he says that he doesn't know what the acronym DIP stands for.

That surprised me: Mr Keohane uses the phrase DIP Financing precisely and accurately and in context and then says he doesn't know what it means. You should note that Mr Keohane is a very sophisticated fixed income player. (If you want a guide to how sophisticated read this...)

The position of the Canadian Government

The Canadian Regulator is put in an extreme bind. Up to $300 million of value has been spirited away from a highly distressed institution.

The regulator however has guaranteed a very large amount of funding of Home Capital (guaranteed deposits). They should be alarmed at up to $4 billion in collateral being spirited away to HOOP. This effectively subordinates the insured depositors and in the event of Home Capital's failure will cost the taxpayer several hundred million dollars.

This is not an idle concern. The funding itself indicates that it is very likely Home Capital will collapse. And a former director described this as akin to DIP Financing.

If I were the regulator

If I were the regulator I would be doing my duty here. My duty here is to protect the taxpayer.

Very rapidly Home Capital needs to find a buyer to assume the government insured obligations. It does not matter if this happens at 20c per share. Indeed from a regulatory perspective it is better if it happens at a low share price because it gets rid of claims of bailouts inducing moral hazard.

If Home Capital cannot find a buyer then it should be liquidated. Immediately. And the transaction with HOOP should be reversed under standard bankruptcy rules for reversing fraudulent conveyance. There is no reason that taxpayers should accept subordination to a loan yielding 15-20 percent.

Indeed regulators have a duty to stop that sort of thing.

John

Disclosure: I am short a modest amount of Home Capital stock so I have a vested interest in its collapse. Canadian taxpayers are on the hook for billions in guarantees. They have a bigger vested interest. Either way this one is toast. But a special sort of toast which allows HOOP to keep all the cream and jam spread.

Also note: this is the first Australian or Canadian mortgage lender to near collapse. That is an important step in the end of the property bubble.

--

It is also worth noting that Wikipedia give a standard list of indicators that fraudulent conveyance has taken place. Most appear to be triggered here.

Becoming insolvent because of the transfer;

Lack or inadequacy of consideration;

Family, or insider relationship among parties;

The retention of possession, benefits or use of property in question;

The existence of the threat of litigation;

The financial situation of the debtor at the time of transfer or after transfer;

The existence or a cumulative effect of a series of transactions after the onset of debtor’s financial difficulties;

19 comments:

Anonymous
said...

In the BNN interview Keohane tried to pretend that the fact that he had been a director would not give him any insight into the state of HCG's loan book- i.e the quality of the collateral, deflecting by saying he was not present during the board discussions. Also, I suppose it depends on what therms any other lending was made to HCG, but how can you just come in and be first in line with every other lender subordinated to someone who came in literally yesterday.

As someone who has done more than a few of these kinds of deals if you go on tv to basically explain that yes, this is like that scene in A Requiem For A Dream where he took it out to breathe you are doing it wrong.

Fraudulent conveyances are fair game within 12 months of a filing and hotly contested - look at UCC litigation re SunEdison Jan 2016 deal. Better to do a lower coupon 2 year deal with a make while on interest.

It's stupid all the way down here. If you are going to asset strip get some legal advice first. These guys can't even do that right.

IMO the Canadian regulator is not going to act as they likely approve of HOOP coming in and their terms are not the issue for the regulator- what would have been an issue the regulator was seeking to avoid would have been the full run on HCG - having to coerce the press to carry pictures of a failing bank with a pallet of money behind the counter just delivered from the Central bank never looks good (seen it). HOOP coming in likely stalled this, so the regulator is not going to rock the boat. let alone tip it over.

The devil (or angel) for the Canadian government will lie in what percentage of the CIDC insured deposits which have not already left (or WILL leave before the $2B door closes) are below the $100K CIDC limit. I would suspect Keohane:1) knows that number, 2) represents a membership base largely paid through CAN-MEDICARE (rendering HOOPP "government adjacent"), 3) judges that the savings to the Canadian taxpayer by HOOPP funding the run on HCG will significantly outweigh remaining CIDC costs and,4) judges the Canadian government would likely see a fraudulent conveyance fight not worth it.

Whether other creditors have the size (and clean hands) to take on the fight is still open.

A massive part of the HOOPP money is spoken for already given the HISA outflows. GICs rollover at something like $600M a month. The HOOPP money might last them 4-6 weeks, potentially. In the meantime it's likely new originations drop to zero. There is no upside in regulators waiting as the contagion has already spread to Equitable and others. They need to move fast and decisively or it will be worse in a month. It's not inconceivable that if they let this keep spiralling that the big 5 could start being affected. Then it's lights out. My gut is HCG may not even open for trading on Monday.

While the loan is certainly a daring exercise in usury, one thing you neglected to mention is OSFI's bungling of all this. The deposit run-off was happening for weeks and accelerated after the OSC announcement. If OSFI stood pat until the 11th hour, the architects of the loan have every excuse to say that something needed to happen quickly. And when you're in need of a deal quick, you might as well start with your Rolodex and skip comparison shopping.

Now as far as the taxpayers being on the hook, HCG has $1.6 billion in net assets and $300M in pre-tax income to work with. The interest would bite into the latter and the security the former, but that only impacts shareholders and who really cares about them.

The taxpayer only gets stuck with the bill if a lot of macro events go wrong. Right now it looks like the mortgages are performing and the assets secured against them are strong. What I find when a lot of people talk about the Toronto housing market, they don't *fear* it will crash. They don't *think* it will crash. They *want* it to crash. These talking heads are practically frothing at the mouth when they speak of a housing collapse. And when you want something to happen, usually the opposite event occurs. It might happen one day, but in the relatively short timeline of picking at HCG's bones before it gets liquidated? I wouldn't bet on it.

As far as a short @ $8. I think it is risky business. I can see the stock price bouncing to $12-$15 on a squeeze. Lots of shorts have already made their money shorting at $30+ and a cover @ $12 versus a cover @ $8 doesn't make a big difference to them. I feel the ER and the OSC hearing will actually be positive catalysts this week, however short-lived. The real fun begins when the GICs start maturing. $6B+ due within the year according to 2016 year-end financials.

With all due respect, I think your legal analysis is way off the mark. There's no subordination - the deposits were/are always unsecured. Also a fraudulent conveyance is when a company sells assets prior to going BK - there's no conveyance here (no sale), nor is there any bankruptcy (at least, not yet). Whether HCG's regulator would need to approve a loan such as this is TBD - depends on what supervisory powers the regulator has by law.

If you're asking "what is the quality of the underlying mortgages?", your head is in the wrong place. Northern Rock wrote *excellent* quality mortgages, which are paying coupons and principal to Granite noteholders as we speak. Even a lot of subprime CDOs ended up being money for the AAA tranches, so why did UBS shareholders lose their money?

The question you need to be asking is "what is the size of HCG's balance sheet, and who is prepared to take the risk of funding it, right now?".

Do they report delinquencies on their loans? It takes time for losses to develop from delinquencies, and this looks like somebody got a wind about the delinquencies and they pull the money out before delinquencies become losses. And it must be Vancouver market, because the sales dropped a while ago, so about now is the time for delinquencies to appear. In a few months delinquencies become defaults. Bank runs don't happen unless there is some basis for it, and nobody talks about what caused it. I would assume the delinquencies hit. It would be interesting to know the scale and geography of those delinquencies.

Lots of people really want a US style housing crash in Canada. Maybe it will happen maybe it won't - at least not in the same way. The default rate in the mortgage market is low and is unchanged over the last 3 years. Home Capital may have a few liar loans - but their default rate is minuscule. The company may not survive this run they've had, but those mortgages (and GIC's) will be sold to other institutions and life will go on. Despite low interest rates, Canada's mortgage lending criteria is very strict. Even more so for CMHC insured mortgages. Let alone that, unlike in the US, people in Canada just don't put the keys in the mailbox and walk away. The mortgages are recourse. They will go after all of your assets including your car to get what they can. It's really a last resort to default on your mortgage in Canada, not an option like many states in the US with their non-recourse mortgages.

In the 80's, western Canada had a terrible housing correction and when the banks repossessed the properties they maintained them for a few years waiting for prices to re-balance and demand to catch up again.

The housing prices have increased substantially and in Toronto, the supply is dismal and can't meet buyer demand. There is a very large transfer of wealth as well. What will cause a crash is increased interest rates (too high and too fast), increase in housing supply, economic recession and unemployment. Home capital going under isn't going to cause a housing crash, but at least John will make some money.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.